America’s Surprising Recovery after V-J Day

This weekend marks the 75th anniversary of V-J Day, the end of World War II. In addition to the victory, Americans should honor the remarkable process that led to it: the rapid transformation of the economy from a Depression-era catastrophe into what President Franklin D. Roosevelt rightly termed the “arsenal of democracy.”

The war ended more quickly than expected, with the unleashing of two atomic bombs on Japan in August 1945. On Sept. 2, Japan formalized its surrender. What came next in the U.S. was equally impressive: the speedy transition from a wartime to a peacetime economy.

It’s hard to believe in retrospect, but many Americans assumed the end of the war would mean a resumption of the Depression, which was cut off by the World War II military buildup. In the middle of the fighting, America’s leading Keynesian economist, Alvin Hansen of Harvard, said: “When the war is over, the government cannot just disband the Army, close down munitions factories, stop building ships, and remove economic controls.” That’s precisely what happened with almost no notice.

When the sudden end of combat became apparent in late August 1945, economist Everett Hagen predicted that the unemployment rate in the first quarter of 1946 would be 14.8%. Millions of military personnel did become jobless within months and defense spending plummeted, putting more out of work. In June 1946 federal employment was almost precisely 10 million less than a year earlier. Yet the sharp rise in overall unemployment didn’t occur. The total unemployment rate for 1946 was 3.9%—almost precisely the same rate the U.S. had this February before the pandemic’s effects were felt.

Part of the reason was that some workers in the war effort wanted to revert to their civilian roles as parents, housewives and students, so the supply of labor fell. But just as critically, market adjustments prevented massive joblessness. Unemployment exists when the quantity of labor supplied exceeds the quantity demanded at prevailing wage levels. To alleviate unemployment, real wages (adjusted for changes in worker productivity) need to fall. That happened in 1946, aided by rising productivity as resources moved from public to more-efficient private uses, with fewer wage and price controls.

Perhaps most interesting for today, all this occurred as the U.S. moved from an extremely expansionary fiscal policy—with budget deficits equal to almost 25% of gross domestic product in 1944 (the equivalent of more than $5 trillion today)—to an extremely contractionary one. The U.S. by 1947 was running a budget surplus exceeding 5% of output—the equivalent of more than $1 trillion today.

Contrast that with today. As in 1945, millions of workers were suddenly released from their jobs. Yet today, Washington has chosen to fight unemployment with deficit spending, deploying various stimulus efforts and unprecedented massive lending to private borrowers at extremely low interest rates. None of that happened after World War II; monetary growth actually slowed from wartime levels. Yet the economy prospered.

This was the complete reverse of the expectation of the newly dominant Keynesian economists, so proponents of that theory later said “pent-up demand” from consumers prevented postwar downturn. While demand for cars, houses and many other consumer goods was indeed robust, supply lags prevented civilian purchases of goods and services from driving the economy. Even in 1947, car production was below the prewar levels of 1940 and 1941. The postwar recovery showed that the corrective powers of markets worked to sustain America’s economic advance.